The Very Long Run: Economic Growth Models
We can measure long run economic as the annual percentage change in per-capita real potential GDP.
Ecoonomic growth causes Y* to move to the right.
The standard of living is measured by the per capita real actual GDP: The average income generated by each individual within an economy
Although a small difference in growth rates may not seem to make a huge difference, compounded over time, smaller changes in growth rates can have a huge impact on economic growth!
-1% growth rate increases GDP by 10% in 10 years
-7% growth rate increases GDP by 100% in 10 years
Even a small change in the growth rate can cause major long term changes in terms of living standards- much more than gap-busting can, anyways...
Malthus thought that output would not be able to grow at a fast enough rate to keep up with population growth
In this unit, we're going to be studying the depressing, Neoclassical growth model, and then we'll be looking at some more optimistic modern growth models.
(As a general note, most asian countries have a much larger growth rate than the rest of the world, currently. This is because they are developing rather rapidly!)
THE PROS AND CONS OF GROWTH
What are some benefits of economic growth?
-Growth may increase the standard of living, as long as the economy is growing more quickly than the population. This means that people are able to buy more crap!
-Economic growth may help governments to alleviate poverty- the more national wealth a country has access to, the greater their ability to redistribute that wealth to those who are worse off.
What are the costs of economic growth?
1: Opportunity Cost: In order to allow for economic growth, individuals need to divert resources away from present consumption and into investment (ie: savings). For an example, a government has the option of spending 100 million dollars on new parks and public spaces now, OR it can spend that money on educating it's citizens, which won't generate any immediate benefit, but will create better workers and a stronger tax base 20 years into the future
2: Personal hardships to those who can't adapt to change (ie: the poor old blacksmith who goes out of business and doesn't want to retrain for a new job more befitting of the information age)
3: NEGATIVE EXTERNALITIES
-Pollution
-Resource Depletion
-Global Warming
-Financial Meltdown
-Congestion
-Stress
-Disease
-Reduced Happiness (if you want to see this sort of thing in action, check out Carl Honore's "In Praise of Slowness"
SOURCES OF ECONOMIC GROWTH
Well, as we learned in the last chapter, in the long run, output is a function of the supply of factors (usually capital and labour, and this includes embodied increases in quality, not just quantity), and productivity (which can also by thought of as technological change)
In this chapter, we flip this idea around and reconfigure it, to state that we have four determinants of growth
1: Supply of labour: the quantity of labour
2: Human capital: the quality of labour (this is acquired through on-the-job training and education)
3: Physical capital: both the quantity and quality of plant, equipment, inventories, and residential construction
4: Technological change: This is sort of a catch-all category for all sorts of different changes, including changes in the productive process, innovation and invention (creative new ideas), new products, new organizations and many other things!
THE NEOCLASSICAL GROWTH MODEL
-Economic growth occurs in the long run, and related to increasing Y*, not output gaps
Long run growth is determined, largely, by investment and savings. In a nutshell, savings allows for more investment, and greater investment in productive capital increases potential output in the long run
In the short run, we assume that the interest rate is constant, so we use the equilibrium condition savings must = investments and use this to determine output
In the long run, we assume that potential GDP is constant, We also see that both savings and investment are a function of the interest rate, so we use the equilibrium condition S = I to determine what the equilibrium interest rate will be.
In this model of savings, we focus on public savings, which is a combination of private savings (Y* - C - T) and public savings (G - T)
NS = (Y* - C - T) + (T - G)
NS = Y* - C - G
When the interest rate increases, we know that consumption will decrease (because the opportunity cost of borrowing money has risen). When consumption decreases while income remains the same, national savings increases. As a result, high interest rates encourage more people to save money, and as a result, this creates a larger "pot" of loanable funds which accumulates in banks. Basically national savings as a function of interest rates is positively sloped.
What about investment????? Well, we use the marginal efficiency of investment curve to measure the degree of investment as a function of interest rates: this curve basically shows the demand for investment at each interest rate
This curve is negatively sloped. As interest rates rise, the opportunity cost of borrowing money to fund new investments also increases, which leads to decreased desired investment.
SO... what happens when we graph both desired national savings and desired investment together? We get two criss-crossing curves! The point where the two curves intersect is where NS = I: this is the equilibrium point- it does not change over time. If there is an excess supply of funds, this will mean that banks do not need to charge as much interest to prospective borrowers, so the interest rates will naturally fall, which drives up investment until it is equal to savings. Likewise, if there is excess demand for loanable funds, banks will know that that loaning out money when there are not many hard assets to cover their asses should the loan go unpaid is RISKY BUSINESS, so they will charge higher interest rates to compensate for this risk. Higher interest rates, likewise, discourages excess investment and encourages national savings until the economy is in equilibrium once again!
An increase in either public savings OR in the marginal efficiency of investment causes the level of equilibrium savings and investment to increase. This increased investment leads to long term increases in potential national income (because investment allows for the accumulation of new capital production factors). As such, although savings can be bad for an economy in the short run (because increased savings puts recessionary pressure on an economy), they are good in the long run, because they create opportunities for new growth! Woooooooooooo!
Wednesday, February 17, 2010
Macroeconomic Timespans
Macroeconomic Time Spans: Changes can have different effects over the long run than they do in the short run! This is just going to be a brief comparison exercise between the long run and the short run.
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IN THE SHORT RUN:
-Changes in national income are a function of factor utilization rate: for an example, the rate of employment. When more people are employed, more factors are being utilized, so national income increases
-National income is demand-induced: aggregate demand determines what the national income is going to be. The higher demand is, the higher the factor utilization rate will have to be in order to sate demand.
-Actual GDP, or Y determines national income: this means that there can be recessionary or inflationary output gaps
-Fiscal and monetary policy can affect both aggregate demand and actual national income
-Policies focus on shifting aggregate demand
-Gapbusting is the political objective
-Policies affect utilization rates
-Policies are focused on stabilizing real GDP at it's potential
IN THE LONG RUN
-Changes in national income are a function of both the supply of factors (ie: the size of the labour force), and factor productivity (ie: how productive and useful, on average, each worker is). The larger the workforce, and the more productive that workforce is, the higher national income will be
-National income is supply-induced: even if demand increases, wages will simply adjust and price will change, but producers will still produce the same amount in the long run UNLESS their production capabilities change. The supply and productivity of factors affects supply, and therefore, can change production in the long run.
-Potential GDP (Y* or Yfe) is a better determinant of what the national income will be. While understanding that output gaps do occur thanks to the business cycle, it is long run aggregate supply which basically determines what GDP will be
-Fiscal and monetary policy have a neutral effect (or even a negative effect: if expansionary policies increase consumption at the expense of savings, then there will be a smaller "pot" for investors to borrow from, so investment will be lower in the long run, causing a lower long run GDP)
-Policies are aimed at affecting potential GDP
-Technological change is key
-Policies attempt to affect factor supply and productivity
-Growth is the political goal
Cool?
Cool! =D
Honestly, just read the chapter for this one: it's short, and it makes more sense than the class notes...
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IN THE SHORT RUN:
-Changes in national income are a function of factor utilization rate: for an example, the rate of employment. When more people are employed, more factors are being utilized, so national income increases
-National income is demand-induced: aggregate demand determines what the national income is going to be. The higher demand is, the higher the factor utilization rate will have to be in order to sate demand.
-Actual GDP, or Y determines national income: this means that there can be recessionary or inflationary output gaps
-Fiscal and monetary policy can affect both aggregate demand and actual national income
-Policies focus on shifting aggregate demand
-Gapbusting is the political objective
-Policies affect utilization rates
-Policies are focused on stabilizing real GDP at it's potential
IN THE LONG RUN
-Changes in national income are a function of both the supply of factors (ie: the size of the labour force), and factor productivity (ie: how productive and useful, on average, each worker is). The larger the workforce, and the more productive that workforce is, the higher national income will be
-National income is supply-induced: even if demand increases, wages will simply adjust and price will change, but producers will still produce the same amount in the long run UNLESS their production capabilities change. The supply and productivity of factors affects supply, and therefore, can change production in the long run.
-Potential GDP (Y* or Yfe) is a better determinant of what the national income will be. While understanding that output gaps do occur thanks to the business cycle, it is long run aggregate supply which basically determines what GDP will be
-Fiscal and monetary policy have a neutral effect (or even a negative effect: if expansionary policies increase consumption at the expense of savings, then there will be a smaller "pot" for investors to borrow from, so investment will be lower in the long run, causing a lower long run GDP)
-Policies are aimed at affecting potential GDP
-Technological change is key
-Policies attempt to affect factor supply and productivity
-Growth is the political goal
Cool?
Cool! =D
Honestly, just read the chapter for this one: it's short, and it makes more sense than the class notes...
Supply and Demand-Side Economics
Long-run aggregate supply, however, can shift if the potential national income shifts. When potential national income increases, this brings the equilibrium price level down, and the equilibrium level of GDP up in the long run. Neoclassical economists believe that policies which intend to bring real economic growth and betterment should focus on shifting potential national income to the right (increasing it): they believe that policies which only focus on increasing aggregate demand merely cause price-inflation in the long run.
So, for a classical economist, instead of using short term fiscal policy "gap-busting" to correct short term deviations from potential national income (boosting or reducing government expenditures to correct recessionary and inflationary gaps), policies should focus on brining potential national income forward, and closing the gap through increased potential economic growth! We call this SUPPLY-SIDE ECONOMICS
SO... let's say that an economy is in an inflationary state... there are a few things which policy-makers can do to fix this
1: They can do nothing. The chain and anchor system of long term economic adjustment will make wages higher, which shifts AS to the left and brings the economy back to Y*, but with a higher price level
2: The government could engage in some "gap-busting" policies (ie: they could raise taxes and decrease expenditures to kick aggregate demand back to the left, which would bring equilibrium GDP back to its potential levels)
3: The government could focus on increasing long run aggregate supply. This is also called Reaganomics: some policies in with vein include cutting personal income taxes (which increases incentives to work), cutting corporate income taxes (which increases production and investment). This shifts LRAS to the right to close the gap, and arguably, there is no negative effect on overall tax revenues, despite these cuts (because the increased long run equilibrium national income creates a larger tax base, so the government is still able to generate the same amount of revenue, despite taxing at lower rates).
CRITICISMS of SUPPLY SIDE ECONOMICS
Although these sorts of policies may increase LRAS, critics note that decreases in personal income tax also increase disposable income, which drives consumption upward. Also, decreases in corporate income tax are likely to cause corporations to increase their levels of investment. Thus, while LRAS will shift to the right, aggregate demand will also shift to the right, and the inflationary gap will persist, even if the economy's productive potential grows. This means that economies where supply side economic policies are instated will experience EVEN LARGER price inflation.
FISCAL POLICY
There are two different models we use for the economy: the short run model and the long run model. These two models are very different.
Fiscal policies which are based on the long run model is focused on increasing economic growth by increasing either labour, capital, or technology. These are factors which cause the potential national income to shift, and thus, they create long-run changes in economic potential.
The short run model, on the other hand, deals with temporary fluctuations in the economy which causes GDP to fall above or below potential: this is the economy model which is centered around the business cycle. Most policies in this vein are based around gap-busting, or eliminating recessionary and inflationary gaps.
It is not particularly difficult to determine the direction of the shift which must be kickstarted by fiscal policies: rather, it is the mixture and the magnitude which is hard to determine (for an example, if lowering taxes is likely to eliminate a recessionary gap, the question which the government must ask is how much of a tax cut should be given, how long should these cuts persist for, and which taxes should be affected by the cut).
STABILIZATION POLICY
-This is meant to damped the fluctuations caused by the business cycle
-This reduces the amplitude of the fluctuations (so recessionary and inflationary gaps are less extreme)
-This is GAPBUSTING!
While the automatic economic adjustment which occurs thanks to natural wages shifts WILL bring economies back to potential GDP, one problem is that the natural adjustment process can take a very long time, and while the economy is adjusting to reduce a recessionary gap, unemployment will be high, and the economy will remain unproductive for a long while. Government stabilization policies can fix recessionary gaps a lot more quickly by increasing government expenditures and decreasing taxation. This boosts aggregate demand, and shifts equilibrium GDP back to Y* a lot more quickly than the natural AS shift to the right would have.
Contractionary fiscal policy works in a very similar way: if there is an inflationary gap, the government increases taxation and decreases government expenditure to shift aggregate demand to the right, thus bringing equilibrium GDP back to Y* much faster than the natural AS shift to the left would have.
THE PARADOX OF THRIFT!
In a recession, the natural tendency is for individuals to increase savings: while such prudent actions may benefit individuals, on a larger aggregate level, frugality decreases consumption, and therefore, it also reduces aggregate expenditures, aggregate demand, and GDP as a whole. As a result, this psychological tendency towards thriftiness in a recession can exacerbate recessionary gaps. A historical example of this occurred in the great depression when governments actually RASIED taxes as a response to the hard economic times.
Note* this negative economic result of savings only really applies to the short run: in the short run, increased savings means decreased consumption, and therefore decreased aggregate demand. In the long run, however (as we will learn in the next chapter), an increase in savings facilitates an increase in investment, which leads to a higher aggregate demand.
AUTOMATIC FISCAL STABILIZATION: This refers to built-in tax and expenditure rates which automatically stabilize the business cycle without the government having to specifically set up any policies
-Basically, tax 'n spend systems decrease the simple multiplier, so injections and withdrawals from the economy create smaller shifts in GDP.
-Automatic stabilization can be represented by the slope of the budget function (as GDP increases, there are more withdrawals from the economy)
-Discretionary stabilization (ie: expansionary and contractionary policies) can be represented by a shift in the budget function (so governments are taxing and spending at different rates for the same national income rate)
-Taxes aren't the only automatic stabilizer: other ones include employment insurance and welfare payments (which are forms of withdrawals or expenditures)
ONE FINAL IMPORTANT THOUGHT: WHY ARE ECONOMISTS SO LEERY ABOUT FISCAL STABILIZATION POLICY???
Why not just increase expenditures and lower taxes to fight unemployment???
Wellll....
There can be policy lags- so by the time a budgetary policy gets through the political process and takes effect, it may already be obsolete, or even counter-productive (remember, stabilization policy is extremely time-sensitive)
Also, economists recognize that many households are not "fooled" by short term changes in tax structures. Many households base their spending on what they believe their long term incomes are going to be (as Milton Friedman predicted), so short term changes in taxation which temporarily boosts income may not cause changes in spending habits.
Finally, most economists believe that fiscal policy creates too broad and general a change in the economic environment to fine tune an economy for optimal performance. While stabilization policy may be useful when large, sweeping economic changes are required, many economists believe that it is unnecessary overkill for small economic imbalances which will correct themselves.
THE LONG TERM EFFECTS OF FISCAL POLICY
While increased government purchases lead to increased AE, AD, and GDP in the short run, in the long run, they may "crowd out" private-sector consumption and investment
Similarly, while decreased taxes may increase AE, AD, and GDP in the short run, the long run effect is less clear. On the one hand, some economists believe that decreased taxes may increase investment and incentive to work in the long run, thus drumming up GDP. On the other hand, some economists believe that decreased taxes may crowd out public spending on public goods (case and point, check out Alberta's decaying public infrastructure)
So, for a classical economist, instead of using short term fiscal policy "gap-busting" to correct short term deviations from potential national income (boosting or reducing government expenditures to correct recessionary and inflationary gaps), policies should focus on brining potential national income forward, and closing the gap through increased potential economic growth! We call this SUPPLY-SIDE ECONOMICS
SO... let's say that an economy is in an inflationary state... there are a few things which policy-makers can do to fix this
1: They can do nothing. The chain and anchor system of long term economic adjustment will make wages higher, which shifts AS to the left and brings the economy back to Y*, but with a higher price level
2: The government could engage in some "gap-busting" policies (ie: they could raise taxes and decrease expenditures to kick aggregate demand back to the left, which would bring equilibrium GDP back to its potential levels)
3: The government could focus on increasing long run aggregate supply. This is also called Reaganomics: some policies in with vein include cutting personal income taxes (which increases incentives to work), cutting corporate income taxes (which increases production and investment). This shifts LRAS to the right to close the gap, and arguably, there is no negative effect on overall tax revenues, despite these cuts (because the increased long run equilibrium national income creates a larger tax base, so the government is still able to generate the same amount of revenue, despite taxing at lower rates).
CRITICISMS of SUPPLY SIDE ECONOMICS
Although these sorts of policies may increase LRAS, critics note that decreases in personal income tax also increase disposable income, which drives consumption upward. Also, decreases in corporate income tax are likely to cause corporations to increase their levels of investment. Thus, while LRAS will shift to the right, aggregate demand will also shift to the right, and the inflationary gap will persist, even if the economy's productive potential grows. This means that economies where supply side economic policies are instated will experience EVEN LARGER price inflation.
FISCAL POLICY
There are two different models we use for the economy: the short run model and the long run model. These two models are very different.
Fiscal policies which are based on the long run model is focused on increasing economic growth by increasing either labour, capital, or technology. These are factors which cause the potential national income to shift, and thus, they create long-run changes in economic potential.
The short run model, on the other hand, deals with temporary fluctuations in the economy which causes GDP to fall above or below potential: this is the economy model which is centered around the business cycle. Most policies in this vein are based around gap-busting, or eliminating recessionary and inflationary gaps.
It is not particularly difficult to determine the direction of the shift which must be kickstarted by fiscal policies: rather, it is the mixture and the magnitude which is hard to determine (for an example, if lowering taxes is likely to eliminate a recessionary gap, the question which the government must ask is how much of a tax cut should be given, how long should these cuts persist for, and which taxes should be affected by the cut).
STABILIZATION POLICY
-This is meant to damped the fluctuations caused by the business cycle
-This reduces the amplitude of the fluctuations (so recessionary and inflationary gaps are less extreme)
-This is GAPBUSTING!
While the automatic economic adjustment which occurs thanks to natural wages shifts WILL bring economies back to potential GDP, one problem is that the natural adjustment process can take a very long time, and while the economy is adjusting to reduce a recessionary gap, unemployment will be high, and the economy will remain unproductive for a long while. Government stabilization policies can fix recessionary gaps a lot more quickly by increasing government expenditures and decreasing taxation. This boosts aggregate demand, and shifts equilibrium GDP back to Y* a lot more quickly than the natural AS shift to the right would have.
Contractionary fiscal policy works in a very similar way: if there is an inflationary gap, the government increases taxation and decreases government expenditure to shift aggregate demand to the right, thus bringing equilibrium GDP back to Y* much faster than the natural AS shift to the left would have.
THE PARADOX OF THRIFT!
In a recession, the natural tendency is for individuals to increase savings: while such prudent actions may benefit individuals, on a larger aggregate level, frugality decreases consumption, and therefore, it also reduces aggregate expenditures, aggregate demand, and GDP as a whole. As a result, this psychological tendency towards thriftiness in a recession can exacerbate recessionary gaps. A historical example of this occurred in the great depression when governments actually RASIED taxes as a response to the hard economic times.
Note* this negative economic result of savings only really applies to the short run: in the short run, increased savings means decreased consumption, and therefore decreased aggregate demand. In the long run, however (as we will learn in the next chapter), an increase in savings facilitates an increase in investment, which leads to a higher aggregate demand.
AUTOMATIC FISCAL STABILIZATION: This refers to built-in tax and expenditure rates which automatically stabilize the business cycle without the government having to specifically set up any policies
-Basically, tax 'n spend systems decrease the simple multiplier, so injections and withdrawals from the economy create smaller shifts in GDP.
-Automatic stabilization can be represented by the slope of the budget function (as GDP increases, there are more withdrawals from the economy)
-Discretionary stabilization (ie: expansionary and contractionary policies) can be represented by a shift in the budget function (so governments are taxing and spending at different rates for the same national income rate)
-Taxes aren't the only automatic stabilizer: other ones include employment insurance and welfare payments (which are forms of withdrawals or expenditures)
ONE FINAL IMPORTANT THOUGHT: WHY ARE ECONOMISTS SO LEERY ABOUT FISCAL STABILIZATION POLICY???
Why not just increase expenditures and lower taxes to fight unemployment???
Wellll....
There can be policy lags- so by the time a budgetary policy gets through the political process and takes effect, it may already be obsolete, or even counter-productive (remember, stabilization policy is extremely time-sensitive)
Also, economists recognize that many households are not "fooled" by short term changes in tax structures. Many households base their spending on what they believe their long term incomes are going to be (as Milton Friedman predicted), so short term changes in taxation which temporarily boosts income may not cause changes in spending habits.
Finally, most economists believe that fiscal policy creates too broad and general a change in the economic environment to fine tune an economy for optimal performance. While stabilization policy may be useful when large, sweeping economic changes are required, many economists believe that it is unnecessary overkill for small economic imbalances which will correct themselves.
THE LONG TERM EFFECTS OF FISCAL POLICY
While increased government purchases lead to increased AE, AD, and GDP in the short run, in the long run, they may "crowd out" private-sector consumption and investment
Similarly, while decreased taxes may increase AE, AD, and GDP in the short run, the long run effect is less clear. On the one hand, some economists believe that decreased taxes may increase investment and incentive to work in the long run, thus drumming up GDP. On the other hand, some economists believe that decreased taxes may crowd out public spending on public goods (case and point, check out Alberta's decaying public infrastructure)
Friday, February 12, 2010
Supply Shocks and Other Important Things!
SUPPLY SHOCKS: These also correct themselves in the long-run, but unlike demand shocks, these do not cause any net changes in the price level.
NEGATIVE SUPPLY SHOCK
-Let's say that the cost of oil rises: this shifts AS to the left, which decreases overall economic output and increases the price level.
-There is now a recessionary gap in the economy, and this will cause unemployment to rise
-As unemployment rises, firms can get away with paying their workers less, so wages fall
-Because wages are a cost, production costs fall, and this shifts aggregate supply to the right, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE
POSITIVE SUPPLY SHOCK
-Let's say that a new technology emerges which lowers the price of electricity: this shifts AS to the right, which increases overall economic output and decreases the price level
-There is now an inflationary gap in the economy, and this will cause unemployment to fall below its natural level
-As unemployment falls wages rise (overtime and worker retention)
-Because wages are a cost, production costs rise, and this shifts aggregate supply to the left, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE
BUT, just because the economy is the same, this doesn't mean that wealth doesn't shift. In the event of a negative supply shock wealth tends to shift from the workers to the capital owners (so workers are paid less, and company owners make more money)
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SHOCKS AND THE BUSINESS CYCLE
Positive supply and demand shocks cause GDP to rise above it's potential level for a period of time, and then to fall back to potential (because inflationary gaps cause decreased unemployment, higher wages, and increased factor prices)
THESE SHOCKS ARE RANDOM...
SO:
The economy's adjustment system accounts for these random shocks, and basicaly incorporates them into business cycles (short term fluctuations of the economy)
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LONG RUN AGGREGATE SUPPLY: This is the relationship between price and GDP after changes in input prices have been taken into account. LRAS is the result of automatic adjustments which bring GDP back to its potential level. LRAS is also called classical aggregate supply, because classical economists assumed that the economy has an automatic tendency to return to Y*
LRAS, graphically, is a vertical line at Y*, because the amount of goods produced at the normal utilization rate is Y*
The only thing which this can be used to demonstrate is price changes: as long as factor prices rise by the same proportion as output prices, then Y*remains constant
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SHIFTING Y*
NEGATIVE SUPPLY SHOCK
-Let's say that the cost of oil rises: this shifts AS to the left, which decreases overall economic output and increases the price level.
-There is now a recessionary gap in the economy, and this will cause unemployment to rise
-As unemployment rises, firms can get away with paying their workers less, so wages fall
-Because wages are a cost, production costs fall, and this shifts aggregate supply to the right, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE
POSITIVE SUPPLY SHOCK
-Let's say that a new technology emerges which lowers the price of electricity: this shifts AS to the right, which increases overall economic output and decreases the price level
-There is now an inflationary gap in the economy, and this will cause unemployment to fall below its natural level
-As unemployment falls wages rise (overtime and worker retention)
-Because wages are a cost, production costs rise, and this shifts aggregate supply to the left, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE
BUT, just because the economy is the same, this doesn't mean that wealth doesn't shift. In the event of a negative supply shock wealth tends to shift from the workers to the capital owners (so workers are paid less, and company owners make more money)
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SHOCKS AND THE BUSINESS CYCLE
Positive supply and demand shocks cause GDP to rise above it's potential level for a period of time, and then to fall back to potential (because inflationary gaps cause decreased unemployment, higher wages, and increased factor prices)
THESE SHOCKS ARE RANDOM...
SO:
The economy's adjustment system accounts for these random shocks, and basicaly incorporates them into business cycles (short term fluctuations of the economy)
--------------------------
LONG RUN AGGREGATE SUPPLY: This is the relationship between price and GDP after changes in input prices have been taken into account. LRAS is the result of automatic adjustments which bring GDP back to its potential level. LRAS is also called classical aggregate supply, because classical economists assumed that the economy has an automatic tendency to return to Y*
LRAS, graphically, is a vertical line at Y*, because the amount of goods produced at the normal utilization rate is Y*
The only thing which this can be used to demonstrate is price changes: as long as factor prices rise by the same proportion as output prices, then Y*remains constant
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SHIFTING Y*
Saturday, January 30, 2010
MACROECONOMIC EQUILIBRIUM: Putting it all Together
So, we have the aggregate supply curve and we have the aggregate demand curve.
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?
Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!
The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment
This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium
Aggregate Demand Shocks and Macroeconomic Equilibrium:
These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!
As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)
You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.
The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.
When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.
When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.
When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.
Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.
We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.
Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.
Okay- that's all you'll need for the test. Good luck!
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?
Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!
The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment
This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium
Aggregate Demand Shocks and Macroeconomic Equilibrium:
These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!
As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)
You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.
The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.
When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.
When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.
When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.
Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.
We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.
Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.
Okay- that's all you'll need for the test. Good luck!
Aggregate Supply
In the short run, we're going to assume that factor prices remain constant (but later on, this can change, as we look at the long run)
The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.
Aggregate Supply is positively sloped!
Why?
Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.
What about the slope? Why is it increasing?
Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)
At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.
Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)
The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.
Aggregate Supply is positively sloped!
Why?
Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.
What about the slope? Why is it increasing?
Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)
At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.
Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)
Aggregate Demand
ECON 101 HELL WEEK BLOG REVIEW:
PART 1: DEMAND SIDE EXPENDITURE
PART 2: SUPPLY SIDE EXPENDITURE
PART 3: EQUILIBRIUM: PUTTING IT TOGETHER
----------------------------------------------------
PART 1: DEMAND SIDE EXPENDITURE
We know that National Income is a function of Aggregate Expenditure. Thus far, we have been assuming that prices remain constant...
Newsflash! In real life, prices change (unless the firms contributing to GDP are monopolies, or they have excess capacity). We need to look at how this affects aggregate expenditure, and subsequently, national income.
We assume that output is demand-determined: that is, GDP will rise if general consumer demand rises, and it will fall with decreases in demand
OKAY: How does price affect aggregate demand? Well, it affects it in an inverse relationship. When the price level increases, aggregate expenditures shift down. When the price level decreases, aggregate expenditures shift up! Why?
2 Reasons:
1: A Decline in Wealth
An increase in price levels causes people's wealth to decrease (unless they have invested into price-variable assets, which most people have not)- inflation decreases the purchasing power of money. Wealth is a ceteris paribus variable for consumption When wealth goes down, peoples' desire to spend (their MPC) also decreases.
2: A Decline in Net Exports
An increase in domestic price levels implies that relatively speaking, foreign products will be cheaper than domestic products. The increases the incentive for domestic consumers to import foreign goods, and it also decreases the incentive for foreign consumers to buy domestic goods. As a result, imports increase (cutting into MPSpend) and exports decrease (lowering autonomous expenditures)
The overall effect is that AE and Prices are negatively related...
SO, what happens when we take the same Aggregate Expenditure curve, and then change the price several times? Well, the equilibrium level of national income will be different for each curve (higher price levels lead to lower expenditures, and therefore lower national income)
When you put together ALL of the different equilibrium income levels for AE, and then graph them in relation to price, you have the Aggregate Demand function!
The Aggregate Demand function is a family of equilibrium national income levels for different price levels! Every point on the AD function is a different equilibrium level.
-The Y-axis is price, and the X-axis is equilibrium national income
-It is downward sloping (As price decreases, equilibrium national income increases)
-Generally speaking, points which are not directly ON the AD function tend to gravitate towards it (because it is a stable equilibrium)
-If income for a certain price level is to the left of the AD curve, it means that for that price level, there is not enough production to satisfy expenditure demands. There are two solutions: firms can make more product (and horizontally move towards the AD curve) or they can raise prices (and vertically move towards the AD curve). More likely, it will be a combination of the two
Shifts in AD are called aggregate demand shocks, and are caused by changes in exogenous, autonomous expenditure (which consequently shifts the whole family of aggregate expenditure curves which we use to derive aggregate demand). If the family of expenditure curves increases, aggregate demand shifts to the right. If the family of expenditure curves decreases, aggregate demand shifts to the left.
The simple multiplier can be used to determine the horizontal shift in AD caused by a demand shock- you just multiply the shock by the simple multiplier, and the AD graph will shift out by that amount for that specific prices level
That's all for this section
PART 1: DEMAND SIDE EXPENDITURE
PART 2: SUPPLY SIDE EXPENDITURE
PART 3: EQUILIBRIUM: PUTTING IT TOGETHER
----------------------------------------------------
PART 1: DEMAND SIDE EXPENDITURE
We know that National Income is a function of Aggregate Expenditure. Thus far, we have been assuming that prices remain constant...
Newsflash! In real life, prices change (unless the firms contributing to GDP are monopolies, or they have excess capacity). We need to look at how this affects aggregate expenditure, and subsequently, national income.
We assume that output is demand-determined: that is, GDP will rise if general consumer demand rises, and it will fall with decreases in demand
OKAY: How does price affect aggregate demand? Well, it affects it in an inverse relationship. When the price level increases, aggregate expenditures shift down. When the price level decreases, aggregate expenditures shift up! Why?
2 Reasons:
1: A Decline in Wealth
An increase in price levels causes people's wealth to decrease (unless they have invested into price-variable assets, which most people have not)- inflation decreases the purchasing power of money. Wealth is a ceteris paribus variable for consumption When wealth goes down, peoples' desire to spend (their MPC) also decreases.
2: A Decline in Net Exports
An increase in domestic price levels implies that relatively speaking, foreign products will be cheaper than domestic products. The increases the incentive for domestic consumers to import foreign goods, and it also decreases the incentive for foreign consumers to buy domestic goods. As a result, imports increase (cutting into MPSpend) and exports decrease (lowering autonomous expenditures)
The overall effect is that AE and Prices are negatively related...
SO, what happens when we take the same Aggregate Expenditure curve, and then change the price several times? Well, the equilibrium level of national income will be different for each curve (higher price levels lead to lower expenditures, and therefore lower national income)
When you put together ALL of the different equilibrium income levels for AE, and then graph them in relation to price, you have the Aggregate Demand function!
The Aggregate Demand function is a family of equilibrium national income levels for different price levels! Every point on the AD function is a different equilibrium level.
-The Y-axis is price, and the X-axis is equilibrium national income
-It is downward sloping (As price decreases, equilibrium national income increases)
-Generally speaking, points which are not directly ON the AD function tend to gravitate towards it (because it is a stable equilibrium)
-If income for a certain price level is to the left of the AD curve, it means that for that price level, there is not enough production to satisfy expenditure demands. There are two solutions: firms can make more product (and horizontally move towards the AD curve) or they can raise prices (and vertically move towards the AD curve). More likely, it will be a combination of the two
Shifts in AD are called aggregate demand shocks, and are caused by changes in exogenous, autonomous expenditure (which consequently shifts the whole family of aggregate expenditure curves which we use to derive aggregate demand). If the family of expenditure curves increases, aggregate demand shifts to the right. If the family of expenditure curves decreases, aggregate demand shifts to the left.
The simple multiplier can be used to determine the horizontal shift in AD caused by a demand shock- you just multiply the shock by the simple multiplier, and the AD graph will shift out by that amount for that specific prices level
That's all for this section
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